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Disasters Down Under: Why Reinsurers are Heeding the Call of Catastrophe

Published: June 21, 2011 in Knowledge@Australian School of Business
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In early May, authorities granted French reinsurer SCOR Global Life a licence to conduct business in Australia. The approval followed a similar agreement reached to allow the company to operate in New Zealand earlier this year. SCOR's chief executive, Gilles Meyer, is happy. "This is a key milestone in terms of generating profitable growth in these major markets," he says. Curiously, Meyer's decision to pursue business in Australasia came only weeks after Frank O'Halloran, the boss of one of Australia's largest general insurers, QBE, insisted that Australia's reinsurance industry was "burning".

Thanks to 2010 being the second worst year for natural disasters since 1980, the insurance industry is under pressure. There were 950 incidents with insured losses amounting to about A$37 billion. In 2011, came floods and a cyclone in Queensland, and an even more severe earthquake in New Zealand. Natural catastrophes in Australia and New Zealand constituted about 16% of global losses last year, with the costliest being the September Christchurch earthquake.

After announcing the company's annual result in February, O'Halloran said he'd secured reinsurance cover until 2013, but painted a grim outlook for the local industry. The reinsurance industry was likely to review its strategy in Australia and New Zealand due to the spate of natural disasters, including the Christchurch earthquake. "So be prepared for pretty tough terms and conditions, and for higher pricing and higher deductibles coming through from reinsurers," O'Halloran warned. "And some of them may not even want to reinsure businesses in Australia or New Zealand at all."

Where O'Halloran can only detect challenges, the head of SCOR's new Australian subsidiary, Craig Ford, sees opportunities. His parent company expects damages of 100 million euro for both the recent earthquake in New Zealand and the floods in Australia, respectively. But, rather than backing off, SCOR is actually extending its range. Michael Sherris, a professor of Actuarial Studies at the Australian School of Business, expects Australia and New Zealand to remain an attractive market for reinsurers. "The Australian reinsurance market has been reasonably profitable over the last few years," he says. "Why pull out now – especially since the market will now become even more profitable?"

Sherris predicts that the markets in the South Pacific will become more attractive. First, reinsurers rely on diversification of risk. "Australia and New Zealand are simply part of that mix, since the actuaries know that damages do not happen simultaneously in all markets," Sherris says. Second, after catastrophes such as the Queensland floods, earthquakes and cyclones, people have become alert to the need to buy insurance, and there is an increase in demand. "In the short term, many more people will be willing to pay for insurance and will be willing to pay higher premiums too," says Sherris. After the January flood in Brisbane demand for insurance increased to the extent that some insurers were reluctant to write policies and were less than willing to meet the demand, harbouring concerns about taking on more business before re-evaluating the risks and the premiums.

Wider coverage at higher premiums leads to greater capacity for insurers to pay for reinsurance, their means of transferring risk. Patrick Snowball, chief executive of Suncorp, one of Australia's general insurers most hit by flood damages, has already flagged a 10% rise in premiums as a result of expected higher reinsurance costs. However, most reinsurance contracts are due for renewal in the new financial year, post-June 30, and Sherris expects the premiums in July to rise considerably. "The increase will be at least 30%, if not north of 40% or 50%, especially when it comes to the coverage of higher levels of risk." Standard & Poor's Australia insurance ratings director Michael Vine sees reinsurance as being only an incremental cost for general insurers. In his view, broad-based premium increases passed on to customers could more than offset any hardening in reinsurance rates.

Painful losses

Right now, it's the damages that are most impressive. Amongst the world's five largest reinsurers, two are German and one is Swiss. Swiss Re chief executive Stefan Lippe says: "The accumulation of natural catastrophe events is expected to turn 2011 into a year with one of the highest historical natural catastrophe claims burdens". Swiss Re reported a loss of US$665 million for the first three months of 2011, compared with a profit of US$158 million a year earlier.

German competitor Munich Re sits on a deficit of 948 billion euro for the first quarter, which heavily contrasts with its result for 2010's final quarter of 485 billion euro surplus. In 2010, Munich Re's profit was 2.4 billion euro – but that's now all in the past. The company expects the payout for Japan, in the wake of the March earthquake and tsunami, to be 1.5 billion euro, plus 1.1 billion euro for floods and cyclones in Australia and the earthquakes in New Zealand.

Hannover Re reports a minimal profit of 52.5 million euro – only a third of 2010's fourth-quarter result of 151 million euro. The combined ratio – measuring net claims incurred plus underwriting expenses as a percentage of net earned premiums – rose to a painful 123.8%. Hannover Re chief executive Ulrich Wallin blames the disasters in the Pacific region with combined damages of 572 million euro. The company's bill for Japan is 232 million euro, and the New Zealand earthquake cost it 152 million euro. Together the catastrophes blew the insurer's annual budget for disasters of 530 million euro – in the first quarter alone.

There are several explanations for why reinsurers ran out of annual budgets after only three months. The premiums they took were too low, the reserves for catastrophes were insufficient or their risk modelling was askew. The last is not unusual. The 2005 disaster wrought by Hurricane Katrina in the south of the US – the world's best-modelled region – showed that many insurers miscalculated the potential damages by 20%. One company was out by 200%, according to Aon Benfield, one of the world's largest intermediaries for the insurance industry.

The development of reinsurance premiums since 2000 does not present a rosy picture, claims Dietmar Zietsch, a professor at the University of Ulm and former chief executive of the German branch of France's SCOR Re Insurance. He points out that in the past 11 years, premiums for general insurances worldwide rose by 80%, whereas reinsurance premiums only rose 66%. Globally, general insurances generate premiums of US$4200 billion annually, whilst reinsurers have to make do with US$200 billion.

The discrepancy is because general insurers around the world only reinsure an average 8% of their premiums, notes Sherris. They do not need to cover their day-to-day business, only the potential for disasters, he points out. Nevertheless, the latest sequence of catastrophes in the Pacific might trigger a long-anticipated premium rise for reinsurers. In turn, this may prompt the creation of new reinsurers in Bermuda, Ireland and other places. "After big events, investors know that more people are willing to pay higher premiums and, consequently, [expect] profitability rises, particularly in a market with a small number of larger players. That's the nature of the market and this will lure new players," Sherris predicts.

Recapitalising on financial markets

The 35 largest players in the global reinsurance market are estimated to be sitting on a combined capital cushion of US$500 billion. But experts are suggesting there is not enough capital in the system to cover major events. "If Los Angeles was to be destroyed by an earthquake, all the reinsurers' capital would be wiped out," says Sherris. "The same situation would result from a man-made disaster such as a major terrorist attack with a chemical or dirty bomb in a major city."

In times of rising liabilities, reinsurers have two options to secure more capital: either to reinsure themselves, a process called "retroceding", or to on-sell the risk into the capital markets through insurance-linked securities (ISL). The health of the industry comes down to a few questions, according to Sherris. "How quickly can reinsurers recapitalise? How quickly can new reinsurers be established? And, how effective can the industry be in finding new ways to access capital in the financial markets?"

Basically, insurance-based securities deliver reinsurance in the form of a bond. Typically, the deal involves a general or reinsurance company exposed to loss and a specialised hedge fund. The insurance then offers the fund a security in exchange for capital for a certain number of years and pays an extra above-the-bank interest rate. Should extraordinary damages occur above a defined threshold within the pre-defined timeframe, the fund loses all or part of its principal. This securitisation tool is not only bought to hedge against natural disasters, but also to reinsure mortality linked or auto insurance risks. So-called "cat" or catastrophe bonds, though, spread exposure by bundling, for example, hurricane risk in the US with earthquake risks in Japan and windstorm risks in Europe.

"The trend toward securitisation has been increasing," observes Sherris. "Whenever there is a major catastrophic event like Katrina this market gets a boost. The recent dramas in the South Pacific are no exception. If rates for reinsurance are pushed up, rates for securitisation contracts become more attractive and investors can provide reinsurance on more attractive terms." Insurers like Swiss Re embrace these contracts because they provide reinsurance without all the regulations of the classic insurance market and that defines the cost advantages of securitisation. According to Aon Benfield, four catastrophe bond issuances closed in the first quarter of 2011, as compared to two issuances in the same period in 2010. In total, the first quarter of 2011 experienced US$1 billion in issuance, versus US$300 million over the same period in 2010.

In the end, not a single company might pull out of Australia and New Zealand. In fact there are even new players such as SCOR on the horizon. Hannover Re has no plans to pull out of the Pacific region, according to board member Michael Pickel. On the contrary, in spite of raging costs the company will deliver more capacity to these markets. "This is how we serve our clients best," he insists. Hannover Re was one of the few organisations that reacted proactively to the September 11, 2001 attacks in the US. Unlike many competitors they took on even more business in North America after the attacks. The same could happen in Australia.

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